Since late February there has been a sharper focus on the risks inherent in financial markets. The catalyst was a 9% drop in the Chinese sharemarket on February 27 that was triggered by a variety of rumours suggesting a crackdown on speculative activity. A fall in the Chinese market of similar magnitude earlier in the year had passed unnoticed. However, the later one came at a time when sensitivities about the US economy were heightened by a string of soft US data and musings from Alan Greenspan, the ex-Chairman of the Federal Reserve. Thus, the prices of stocks in China triggered a slump felt - albeit briefly - in financial markets around the globe.

The direct impact of the equity market meltdown had a very modest impact on NZ's share market, which dropped 1.5% on the day - putting the NZX50 back to a level last seen in early January. But two side effects of a wider focus on risk were of more interest from an NZ perspective.

For one, we saw some reappraisal of 'carry' trades, essentially the borrowing of low-interest rate currencies to fund investments in high-interest rate currencies. One example of a carry trade is borrowing yen (Japan's official interest rate is 0.5%) and investing in NZD (the Official Cash Rate is 7.75%).

Such investments have been likened to "picking up nickels in front of steamrollers". As long as volatility in currency markets remains low the trades will generally pay off. But a sharp drop in the currency with the high interest yield can very quickly wipe out any gains and even deliver a nasty loss - steamrollers are unforgiving. The jolt that markets got also saw the risks of such trades get looked at a little harder. The result was some of these trades got cut: the high-yielding currencies were sold and the yen bought. The NZD consequently fell, particularly so against the yen.

The heightened concern over the riskiness of these trades has died back for now - indeed, the NZD/JPY has since hit its highest level since 1990!

However, the episode was a timely reminder that 'hot money' chasing high NZ interest rates has formed part of the updraft lifting the NZD higher in recent years, and under changed circumstances can swiftly become a downdraft. High interest rates are underpinning the NZD for now, but a sea change in sentiment on interest rates could easily have a marked impact on the NZD.

The RBNZ has also given a subtle reminder that the NZD is not a one-way bet.

The other risk that came to the fore was rising problem loans in the US 'subprime' mortgage market, that part of the mortgage market lending to borrowers of much lower credit quality than the mainstream banks lend to. In 2000 the subprime market accounted for only 5.6% by value of US mortgages, but hit 20% in 2006. Some of these subprime loans face adjustable rates that are reset periodically, and prevailing market rates have climbed. Furthermore, the products on offer became increasingly exotic and perhaps not well understood by some borrowers, such as negative amortisation mortgages.

A growing proportion of loans in the sub-prime space are in arrears, and foreclosures are up 25% over the past year. Some fraudulent loans have also been surfacing, with fictional earnings given for loans where no supporting documentation is necessary (some loans have never had a repayment made on them). And with house prices falling in some areas, some borrowers may be facing not just higher debt servicing but negative equity in their home. A large number of specialist firms popped up to serve this lower end of the market, and several have run into financial trouble.

Where does this all fit into a relook at market risk? The difficulties that some subprime lenders hit sent share prices in the sector falling. There was some fallout on companies and investors who have funded subprime lenders. And there is the impact on the pricing of credit risk. The bulk of US mortgages are bundled up and sold as mortgage-backed bonds, which make up 20% of the global fixed income market. Problems with defaulting mortgages might result in a greater credit risk premium being built into securities beyond the specialised higher-risk products backed by subprime mortgages. However, there are few signs of such spillover to date.

The New Zealand Economy

Though 2007 will see a slight moderation of pace, the international economy has become more balanced amongst the three main economic blocs: the US, Europe, and Japan.

• World growth will achieve 5%;
• Interest rates have partially normalised, with more increases likely over time in Europe and Japan;
• Underlying inflation pressures remain, though headline inflation has been trimmed back by the late 2006 drop in petrol prices.
  

US growth will soften a touch Given the importance of the US consumer to the global economy, the fortunes of the US housing market will continue to be closely watched by many. However, we expect the US economy will remain in reasonable shape:

• Growth in 2007 will moderate to 2.5%;
• The labour market will remain resilient;
• Elevated inflation will continue to concern the Federal Reserve over much of 2007;
• And, consequently, US interest rates are unlikely to be cut this year.

The other global engines are holding up:

• Europe will growth around 2%, in line with its long-run potential;
• Japan is still getting back on its feet, and the Bank of Japan is being circumspect about the pace at which it lifts interest rates.
• China continues to grow rapidly and will exert ongoing pressure on raw materials.
• Australia, NZ's closest trading partner, will grow a shade under 3% this year, but is also suffering from drought.

Risks that could blunt the global economy include:

• US housing may yet see fallout from mortgage defaults (as discussed in the preceding section);
• Oil prices have soared again recently, in part on renewed geopolitical tensions;
• Japan's recovery has yet to trickle down to the household sector;
• And the imbalances globally between high savers (e.g. Asia and oil-producing countries) and indebted countries (including New Zealand) remain ever large.

The NZ economy appears to have quickly shrugged off the impact of last year's soaring fuel prices - as well as developing a degree of immunity to the interest rate increases the RBNZ delivered back in 2004 and 2005.

Economic activity has clearly lifted back after being depressed during the middle portion of 2006. GDP growth in 2006Q4 lifted to 0.8% for the quarter after a subdued 0.3% in Q3. Annual average growth of 1.8% for 2006 as a whole will likely be the trough for this recent slowdown.
A number of forward indicators suggest some of the recent momentum remains:

• House price growth has reaccelerated, with a smoothed 3-month average of the median house price rising at an annual rate of 13.9% in April;
• Days taken to sell a house have reduced, consistent with a market that is supply constrained (and explaining why turnover hasn't surged too dramatically);
• House price expectations in the ASB Housing Confidence survey is up at levels not seen since 2003 when the housing boom was at its strongest;
• Consumer confidence has recovered from its mid-2006 slump;

The RBNZ has lifted interest rates based on an assessment that renewed economic strength threatens to push inflation back above 3% in 2008/09.

But the side-effect of the RBNZ's response has contributed to a resurgent NZ dollar. In turn, exporters and import-competers will endure further extreme pressure and have to wait that much longer before a lower exchange rate brings them some welcome relief.

The dairy industry is perhaps the one export industry receiving some shelter from the high NZD, thanks to record levels for dairy prices on world markets.

The upshot is that for large parts of 2007 the economy will remain extremely imbalanced, with the long-awaited rebalancing delayed.
Nevertheless, the current account deficit does now appear to have peaked in mid 2006 at an annual deficit equivalent to 9.7% of GDP. Subsequent narrowing has been modest, and that will remain the case for 2007.

Finding balance is an essential part of re-establishing a foundation for the next sustainable upswing in the economy. That requires greater export earnings and less reliance on debt-fuelled spending.

The housing market will be a key influence this year on: construction, consumer spending, inflation and financial markets. Other factors buoying domestic demand are a still-tight labour market and strong wage growth, as well as a boost in the net fiscal stimulus to the economy.
All up, 2007 will see growth approach 2.5% as the uptick persists over the first half of 2007, with 2008 growing at around 2%.

Whether interest rates get raised further this year depends much on whether this latest uptick in domestic spending is relatively short-lived or is more enduring.

The RBNZ will remain concerned about the inflation outlook given that:

• Surveyed capacity constraints have started to edge up;
• Difficulties in finding labour are also growing and the labour market will remain tight;
• Low productivity and high wages will keep up pressure on labour costs;
• Inflation expectations and pricing intentions have declined from their peaks but still remain relatively elevated.
  

Inflation itself will continue to fall through to September 2007 through the benefit of the 2006H2 slump in petrol prices, hitting a low below 2%.
However, once that impact wears off the underlying inflation picture will resurface, pushing headline inflation back to 2.5% by end-2007 and holding it near that level over 2008.
That lack of perceived headroom to tolerate further signs of inflation pressure means there is still some residual risk the RBNZ lifts the OCR further in 2007.

Our view is that the RBNZ will now keep the OCR on hold at 7.75% throughout 2007. But given the latent strength of domestic demand, the risks over 2007 are still skewed to higher, rather than lower, rates.

• Factors that will, however, buy the RBNZ some breathing room are:
• The NZ dollar has strengthened substantially and is likely to dampen activity/inflation for longer than the RBNZ assumed in its March forecasts;
• Mortgage rates have risen sharply to date this year, delivering more bite.

We expect the RBNZ will relax its grip, but not until the first half of 2008 once it is clear that domestic inflation pressures are comfortably under control.

Long-term interest rates will remain propped up for much of 2007. The RBNZ's still-tough stance will, in particular, underpin the 1 and 2-year swap rates at high levels.

Much of the eventual movement in the yield curve will come at the front end once it is clear that the RBNZ is on top of inflation and some reduction of monetary tightness looks warranted.

Meanwhile, the NZ dollar could well be held up at/above the USD 70 cent mark for much of 2007. The ongoing risk of still-higher interest rates - and likelihood of rates remaining high throughout this year - will continue to attract funds into NZ and hold the NZD up. Strong commodity prices (albeit largely dairy) will also contribute.
As was demonstrated graphically in the first half of last year, the most pivotal trigger for NZD depreciation will be the swing in OCR expectations to lower rates. And actual OCR cuts occurring will be what then holds the NZD down on a sustained basis.

Other reasons for eventual decline in the NZ dollar are:

• Economic growth will be reasonable but not spectacular;
• The large current account deficit still requires a high degree of funding;
• Maturities of NZD-denominated global bonds will start to increase in the second half of 2007.
• The NZD should start to soften in the second half of 2007, heading towards USD 60 cents over 2008.